Thank you for not being a petulant child AIG…

I forgot how this thing works. Since I’ve last written, I took the CFA exam again, we’ve had fiscal cliffs, an election, and all sorts of other stuff. I meant to write a post called “All I want for Christmas is not to go over the fiscal cliff…” but alas, holiday season intervened.

Regardless, there’s some news that came out earlier this week that the former CEO of AIG, Maurice Greenberg, was going to sue the Federal Government for parts of the bailout. Among them were the was a high 14% interest rate that they had to pay on funds and the fact that the previous shares were diluted when the government provided the funds.

Thankfully, AIG has decided not to partake in the lawsuit.

The complexities in this case can not all be explained in the space I have here. One thing I do want to say is that I’ve been against bailouts in general. I don’t see why taxpayers should have to front the bill for bad business practices, no matter how bad the economy will go down if a corporation goes bankrupt.

That being said, AIG’s bailout was good for both the firm itself, government, and to an extent, taxpayers! How is it good for government and taxpayers? Very simple. They made a profit. Our government is still heavily in debt and I see us approaching another debt ceiling before we actually get our ducks in a row, but this at least helps. Additionally, the country (and the world) does not have to endure the economic pains of a major financial institution going under.

For AIG, they still exist. They did not file bankruptcy. Share prices are not only higher than they were back in 2008, but the company itself is in another position. I’d considering actually owning this stock now. I mean, PE at under 3 for that big of a firm?

And now the former CEO is complaining that he didn’t get enough. Yay America.

How to clear some of the smoke on the Volcker Rule

The Volcker Rule is a bit hazy...

Over the past couple years there has been a lot of talk about the Volcker Rule. Basically this rule prohibits banks from taking safe assets and putting them up against liabilities as a result of proprietary trading. Essentially, the idea is that if you deposit money in the bank, you shouldn’t have to worry about the FDIC backing your deposits as a result of your bank engaging in trading that may tumble. The problem with this is defining what’s market making and what’s proprietary trading.

When it comes to equities, most equities at least, is that there is generally a good market for them. And for the ones that are illiquid, it doesn’t require much capital to hold to them. But with bonds and and other instruments, it requires a large amount of capital to hold on to these positions. By limiting the amount of money banks have to hold these positions, you will be holding back the amount of money they can spend on certain instruments, most notably municipal bonds and non-US sovereign bonds.

The latter is a significant problem because holding back on holding back certain instruments may upset some countries. How would large growing economies respond if the US started to suddenly sell their bonds? Given that it will actually increase their interest rates but decrease exchange rates. This helps because it makes their exports cheaper but also increases their borrowing costs. For smaller emerging economies, the effect on their interest rate will be less, essentially making it a good thing because they are more able to compete with the US while not raising their borrowing rates dramatically.

This isn’t calling the Volcker a complete disaster. There are solutions. Instead of making banks sell these positions, why not require them to hedge against them? Make them buy credit default swaps on some of the riskier debt. Now the problem with this being that to purchase credit default swaps, which is essentially a put option on interest rates, is that someone has to take the other side. Plenty of mutual funds now will also have a problem with the Volcker Rule. But they could also engage in the CDS market to take the other side of trades. Which saves AIG from drowning again.

Maybe it’s not a perfect solution, but it’s a start.

Links:
http://www.cfainstitute.org/newsletter/advocacy/volcker_rule.html
http://www.cfainstitute.org/Comment%20Letters/20120215.pdf

AIG is doomed

I remember watching plenty of soccer (football/futbol) matches. More specifically the 2009 Champions League Final between Barcelona and Manchester United. At the time, Manchester United was sponsored by AIG, which had received a $85 billion (which got up to $182 billion) credit facility from the US government. I just loved the irony that the American public was sponsoring a football club in the UK. Honestly, I laughed then and the joke still isn’t old. I honestly thought they should replace the AIG logo with a picture of Uncle Sam or the American flag.

This week, AIG announced they would be looking to raise $6 billion in order to help pay back the credit facility. In order to do this, they plan on selling AIA Group, an Asia based insurance holding company. While AIG certainly is in desperate need of some cash to pay back the US Treasury, I worry about the long term prospects of AIG.

As a result of taking the bullish side of the first credit default swaps, AIG really hurt itself as a firm*. In order to meet short term liquidity issues, it had to complicate its long term solvency. Meaning, it had to forego its long term credit for short term credit. Now, the bills are coming due and AIG has to trim the fat. The main issue I have with them selling off assets is that it will reduce the diversification of the firm.

Not only that, I believe that AIG’s sell of AIA is just the beginning. I’m pretty sure more will be coming. After this, AIG will have raised $6 billion of the money they need to pay back. Afterwards, they will owe about $42 billion back.

* Credit default swaps – A credit default swap is best thought of as insurance on a bond. You can buy a credit default swap on Greek debt. If Greek fails to live up to its debt obligations and defaults, you get paid. Think like a put option. You pay a premium for downside risk. You don’t have to own the underlying asset.